What is depreciation and why is it important?
Depreciation refers to the gradual loss of value of a rental property over time due to wear and tear. While the land itself does not depreciate, the structure, appliances, and land improvements do. The IRS allows landlords to claim this loss as a tax deduction, effectively spreading the cost of the property over its useful life. Although straight-line depreciation is the most common, other types of depreciation can significantly benefit landlords if used properly.
Benefits of depreciation for landlords
Depreciation is more than just a tax deduction, it is a powerful tool that directly impacts a landlord’s bottom line. By understanding and leveraging depreciation, property owners can significantly reduce their tax liability, free up cash for investments, and strategically plan for long-term financial success. Below are some benefits that every landlord should be aware of regarding depreciation.
Depreciation offers several key advantages:
| Benefit | Description |
|---|---|
| Reduce taxable income | By deducting depreciation, landlords lower their tax liability. |
| Increase cash flow | Tax savings mean more funds available to reinvest in properties or cover expenses. |
| Enhance long-term financial planning | Properly tracking depreciation allows landlords to optimize their portfolio’s profitability. |
Key depreciation rules for rental properties
To truly maximize all the benefits that depreciation has to offer, landlords must follow specific IRS rules and guidelines. Getting a grasp on what qualifies for depreciation, how to allocate costs, and what is excluded ensures compliance and helps avoid costly mistakes. Below are the rules every landlord should know when calculating depreciation for their rental properties.
IRS guidelines for depreciation
To claim depreciation, landlords must ensure their property meets IRS requirements. These rules determine which properties and components qualify for this valuable tax benefit:
- The property must be used for business or income-generating purposes.
Depreciation applies only to properties that generate rental income. For mixed-use properties (e.g., a duplex where 60% is rented out), you can depreciate only the rental portion. - The property must have a determinable useful life.
Properties and components must wear out or deteriorate over time. While buildings qualify, raw land does not, as it has an indefinite lifespan and does not depreciate. - The property must be owned by the taxpayer.
Only property owned outright qualifies for depreciation. Leased or rented properties cannot be depreciated by the tenant, even if they generate income.
Components eligible for depreciation
Rental properties are made up of various components, many of which qualify for depreciation. Each component has its own depreciation schedule based on the IRS guidelines. The table below outlines these components and their eligibility:
| Component | Description | Depreciation Period |
|---|---|---|
| Building structure | The primary structure of the rental property, such as walls, roof, and foundation, used for rental purposes. | 27.5 years (residential) or 39 years (commercial) |
| Personal property | Items within the property that are not permanently attached, including appliances, furniture, and fixtures. | 5–7 years |
| Land improvements | Features added to the land, such as landscaping, fences, parking lots, and driveways, that enhance usability. | 15 years |
What doesn’t qualify for depreciation
While many components of a rental property are eligible for depreciation, there are certain exclusions that landlords must be aware of. Knowing what cannot be depreciated is just as important as understanding what qualifies, as claiming ineligible deductions can lead to IRS penalties. Below is a breakdown of the most common exclusions:
| Component | Description | Reason for Ineligibility |
|---|---|---|
| Land value | The value of the land on which the rental property is built. | Land does not wear out, lose value, or have a determinable useful life. |
| Personal use property | Portions of the property used personally by the owner, such as a vacation home or a primary residence. | Only the portion of the property generating rental income is eligible for depreciation. |
How to calculate depreciation on rental property
Step-by-step guide
- Determine the property’s cost basis
This includes the purchase price and any costs associated with acquiring the property (e.g., legal fees, closing costs). Improvements like renovations also add to the cost basis. - Subtract the value of the land
Since land isn’t depreciable, its value must be excluded from the total cost. Use tax assessments or appraisals to separate land and building values. - Allocate costs to components
Break down the property’s cost into categories like the building, personal property, and land improvements. Accurate allocation ensures maximum deductions. - Apply IRS depreciation schedules
Use the appropriate schedule for each component to calculate annual depreciation. For example:- Building structure: Straight-line method over 27.5 years
- Appliances: 5-year schedule
- Landscaping: 15-year schedule
Depreciation methods and schedules
Understanding the different methods and schedules for depreciation is essential for landlords to maximize their tax benefits. The IRS provides specific guidelines for how rental property and its components should be depreciated over time. Below, we’ll explore the most common methods, including straight-line depreciation, and how they apply to different property types.
| Method | Applicable Property | Recovery Period | Depreciation Pattern | Key Benefits |
|---|---|---|---|---|
| Straight-Line | All real estate properties | 27.5 years (residential) / 39 years (commercial) | Even annual deductions | Simplicity and consistency |
| Cost Segregation | Primarily commercial and large residential properties | Varies by component (5, 7, 15 years) | Accelerated deductions for reclassified components | Increased early-year deductions and cash flow |
| Bonus Depreciation | Components identified via cost segregation | First year of service | Significant first-year deduction | Immediate tax relief and enhanced cash flow |
| MACRS | All depreciable real estate assets | Varies (generally aligns with Straight-Line) | Governed by IRS guidelines | Compliance with tax regulations |
| Section 179 | Personal property associated with real estate | Current tax year | Immediate expensing up to limits | Immediate tax deduction for qualifying assets |
| Rehabilitation Credit Depreciation | Historic or distressed properties | Varies based on rehabilitation | May offer accelerated or specialized deductions | Incentives for property preservation and restoration |
Straight-line depreciation
The most common method, straight-line depreciation, spreads the cost of the property evenly over its useful life. This means that landlords deduct the same amount every year until the property’s value is fully depreciated. It’s a simple and predictable method, which makes it particularly popular for residential and commercial rental properties.
For residential properties, the IRS assigns a 27.5-year depreciation schedule, while commercial properties are depreciated over 39 years. This schedule applies only to the building structure and any eligible improvements, excluding land value, which is not depreciable.
Key formula for straight-line depreciation:
Where:
- Depreciable Value is the total cost of the property minus the value of the land.
- Useful Life is 27.5 years for residential properties and 39 years for commercial properties.
Real-life example: Straight-line depreciation in action
Meet Sarah, a new landlord
Sarah recently purchased a residential rental property for $330,000 in a suburban neighborhood. After reviewing her purchase agreement and local tax assessment, she determined that $55,000 of the purchase price is attributed to the land, leaving $275,000 as the depreciable value of the building.
Because this is a residential property, Sarah must use the 27.5-year straight-line depreciation schedule to calculate her annual deductions.
| Step | Description | Calculation |
|---|---|---|
| Determine the depreciable value | Subtract the land value from the total purchase price to find the depreciable value of the building. | $330,000 – $55,000 = $275,000 |
| Calculate annual depreciation | Divide the depreciable value by the useful life of the property (27.5 years for residential rental properties). | $275,000 ÷ 27.5 = $10,000 per year |
| Apply annual depreciation over time | Claim $10,000 as a tax deduction each year for the next 27.5 years, as long as the property remains a rental. | Annual deduction: $10,000/year |
How straight-line depreciation impacts Sarah’s finances
In her first year as a landlord, Sarah’s rental property generates $25,000 in rental income. She also incurs $8,000 in operating expenses for property management, repairs, and utilities. Without depreciation, her taxable rental income would be:
- Rental income: $25,000
- Operating expenses: $8,000
- Taxable income before depreciation: $25,000 – $8,000 = $17,000
By applying the $10,000 depreciation deduction, Sarah lowers her taxable rental income:
- Taxable income after depreciation: $17,000 – $10,000 = $7,000
This means Sarah only pays taxes on $7,000 instead of $17,000, saving her a significant amount of money.
So why is tax so important? We asked Gerti Mema of Equipment Finance Canada why he thinks tax is so important when looking at things like profit:
The reason it is important to incorporate a tax strategy into an investment portfolio is to avoid unnecessary tax liabilities that eat into your profits. Many business owners focus on returns, but they tend to overlook how taxes are able to take a large portion of those earnings if they are not properly structured.
Accelerated depreciation methods: MACRS, cost segregation, and bonus depreciation
While straight-line depreciation spreads deductions evenly over a property’s useful life, accelerated depreciation methods allow landlords to claim larger deductions upfront. These strategies, MACRS, cost segregation, and bonus depreciation, help property owners maximize early-year tax savings and improve cash flow. Each method has specific applications, but they often work together to optimize depreciation benefits.
- MACRS (Modified Accelerated Cost Recovery System): The standard IRS-approved method for accelerated depreciation. It assigns shorter recovery periods to certain property components, allowing for larger deductions in the first few years.
- Cost segregation: A tax strategy that reclassifies property components into shorter depreciation schedules (5, 7, or 15 years) instead of the standard 27.5 or 39 years.
- Bonus depreciation: A provision that allows landlords to deduct a significant portion (or even 100%) of eligible asset costs in the first year.
How MACRS is calculated
MACRS applies specific IRS-defined percentages to the depreciable value of an asset over its recovery period. For example, appliances fall under the 5-year recovery period and use the 200% declining balance method, with depreciation rates as follows:
| Year | Depreciation Percentage |
|---|---|
| 1 | 20% |
| 2 | 32% |
| 3 | 19.2% |
| 4 | 11.52% |
| 5 | 11.52% |
| 6 (final adjustment) | 5.76% |
Using these percentages, a $10,000 appliance would depreciate by $2,000 in the first year (20% of $10,000) and $3,200 in the second year (32% of $10,000). This accelerated schedule allows landlords to claim larger deductions upfront, maximizing early tax savings.
Short-term rentals are one of the main drivers of our clients using cost segregation studies, but there are some issues. At least that’s according to Michael Roberts, co-founder of City Creek Mortgages
They also usually bring in more cash than long-term leases. It’s not unheard of for people to earn in a week what they’d get from a long-term tenant in a month.
There is a downside of course. There’s no guarantee you’ll always have a tenant at the time you’d like to. And there’s definitely an inconsistency in income. In a long-term lease, you know exactly what to expect each month but with short-term rentals, you’ll have gaps between bookings. Still, if you’re in a good location and like living in the space, I’d say it’s worthwhile. At the end of the day, it’s what you’re getting out of it and that could just be more time-off for yourself.
Real-life example: Accelerating depreciation with MACRS
Meet James, a landlord optimizing his rental property deductions
James owns a residential rental property he purchased for $200,000. The land is valued at $40,000, leaving $160,000 for depreciation. James decides to use MACRS to accelerate deductions for some components.
| Component | Value | Depreciation Method | Depreciation Period |
|---|---|---|---|
| Building structure | $120,000 | Straight-line depreciation | 27.5 years |
| Appliances and furniture | $30,000 | MACRS | 5 years |
| Land improvements | $10,000 | MACRS | 15 years |
- Calculate depreciation for the first year:
- Building structure: $120,000 ÷ 27.5 = $4,364
- Appliances and furniture (Year 1, MACRS 5-year schedule): $30,000 × 20% = $6,000
- Land improvements (Year 1, MACRS 15-year schedule): $10,000 × 5% = $500
- Total first-year depreciation:
$4,364 (building) + $6,000 (appliances) + $500 (land improvements) = $10,864
Section 179: Immediate expensing for qualifying assets
Section 179 allows landlords to deduct the full cost of qualifying personal property associated with rental real estate in the year of purchase, rather than depreciating it over time. This includes items like appliances, office equipment, and security systems, but not the building itself or structural components.
Key benefits:
- Provides an immediate tax deduction rather than spreading costs over several years.
- Ideal for landlords to make significant improvements in a single tax year.
- Subject to annual deduction limits set by the IRS.
Example: If a landlord spends $20,000 on new kitchen appliances for rental units, they may be able to deduct the full amount under Section 179 instead of using MACRS over five years.
Rehabilitation credit depreciation: Incentives for historic and distressed properties
The Rehabilitation Tax Credit, also known as Rehabilitation Credit Depreciation, encourages landlords to restore historic or distressed buildings by offering tax credits on qualified renovation costs. This applies to properties that are:
- Certified historic structures (eligible for a 20% tax credit).
- Non-historic buildings used for commercial purposes (eligible for a 10% tax credit if placed in service before 1936).
Key benefits:
- Offsets renovation costs through tax credits instead of standard depreciation.
- Encourages property preservation and revitalization.
- Must meet strict IRS and National Park Service guidelines to qualify.
Example: A landlord rehabilitates a historic apartment building, spending $500,000 on qualified improvements. If eligible, they could claim a 20% tax credit ($100,000 in tax savings) rather than slowly depreciating the renovation costs.
Still unsure how depreciation works—or how to actually use it to lower your tax bill?
Download our free guide, Depreciation 101: A Front-to-Back Guide, and learn how savvy investors accelerate their write-offs, boost cash flow, and reinvest faster using strategies like cost segregation and bonus depreciation.
Tools and resources for landlords
Landlords have access to various tools to optimize their tax strategies and maximize depreciation benefits. Among these, cost segregation studies stand out as a powerful method for accelerating depreciation and increasing cash flow. Here’s a closer look at key resources:
Cost segregation studies: A powerful tax strategy
A cost segregation study is an advanced tax strategy that accelerates depreciation by breaking down a property into its individual components and assigning each one to its appropriate depreciation schedule. Instead of lumping the entire building into a 27.5- or 39-year schedule, the study identifies components like appliances, electrical systems, carpeting, and landscaping that can be depreciated over shorter periods, such as 5, 7, or 15 years.
How it works:
- A cost segregation specialist analyzes the property to separate its components into categories eligible for accelerated depreciation.
- These components are then assigned to shorter depreciation schedules based on IRS guidelines.
- Landlords can claim larger deductions in the early years of ownership, reducing taxable income and increasing cash flow.
Why it’s beneficial for landlords:
- Higher upfront tax savings: Accelerating depreciation means more significant deductions in the earlier years, which can be reinvested into property improvements or acquisitions.
- Improved cash flow: By reducing tax liabilities upfront, landlords free up funds for reinvestment or operational expenses.
- Tailored for high-value assets: Cost segregation is particularly effective for properties with a purchase price exceeding $500,000, but even smaller properties can benefit significantly.
Depreciation calculators
Depreciation calculators are quick tools for estimating deductions but lack the precision of cost segregation studies. While helpful for simple properties, they cannot account for the benefits of accelerated depreciation.
Professional tax advisors
Tax advisors help ensure IRS compliance and maximize savings by tailoring depreciation strategies to individual portfolios. Combining their expertise with cost segregation studies offers landlords the greatest financial advantage.
FAQ
Can I change depreciation methods after I’ve started?
No, once you choose a depreciation method (e.g., straight-line or MACRS), you must stick with it for the duration of the asset’s recovery period. However, if you realize you’ve made an error in your depreciation schedule, you can file an amended return or request a change in accounting method with the IRS.
What happens to depreciation when I sell my rental property?
When you sell a rental property, the IRS may require you to “recapture” the depreciation you’ve claimed over the years. This means you’ll pay taxes on the depreciation deductions at a rate of up to 25%. Proper planning with a tax professional can help you minimize this impact.
Can I claim depreciation if my property was vacant for part of the year?
Yes, as long as the property was available for rent during the year, you can claim depreciation even if it was vacant for some time. The key is that the property must be ready and available for rental use, even if no tenants occupied it during that period.
